The Japan Earthquake in American Debt.

Japan is about to undertake one of the biggest rebuilding efforts since the end of World War II. The country has to replace everything from airports and runways to bridges, ports, roads, highways, train tracks, power stations, houses, shopping centers, schools, hospitals, utility and cell-phone towers, parking garages, post offices, production plants... the list would take pages to print out.

The effort is going to cost tens, and more likely, hundreds of billions of U.S. dollars to accomplish.

Japan is fortunate in that it is one of the world’s wealthiest nations, and the citizenry is exceedingly patriotic. As such, Japan has the wealth to accomplish the mission Mother Nature has forced upon the island nation. And it has a population willing to put to work its own savings to rebuild Sendai, Minami-sanriku, Fukushima and others.

But just like pushing on an inflated balloon causes distortions elsewhere, Japan’s now singular focus on a domestic emergency means it has little interest in playing in U.S. Treasury and equity markets.

Indeed, it seems highly likely that Japan will be a net seller off U.S. debt and U.S. equities as Japan’s government, companies and citizens raise cash to fund the rebuilding.

That will have knock-on effects in America.

If Japan Disappears from the Treasury Market --- Then What?

All told, Japan owns an estimated $3 trillion of U.S. securities, both stocks and bonds. With $886 billion of U.S. Treasuries, Japan is the world’s #2-holder of U.S. debt. In the past year it’s bought, on average, $10 billion worth of Treasuries every month.

You don’t easily replace the second-largest buyer of Treasury bills, bonds and notes. Not many countries have pockets deep enough to step up with that kind of financial firepower.

China does, but it already owns more U.S. debt than it needs, and has been putting its cash into other currencies and gold out of a sense of financial prudence. Some of the Middle East nations could pick up some of the slack... but they have their own uprisings to quiet. They’re throwing bags of cash at protestors to quash the dissent, or at security personnel to quash the protestors.

The U.S. Will Have Little Choice But to Raise Interest Rates

A more likely scenario is that Japan largely disappears from the Treasury market, with China and a few others filling in some of that vacuum. And the Federal Reserve, which is slated to end it QE II campaign in June, will likely extend the remainder of its $600 billion buying program over several more months.

But it doesn’t seem likely that the willpower exists in Washington for the Fed to increase the size of QE II [and the resultant inflation]. And that means there will be some shortfall. And shortfalls are bad for the U.S. government because the government has a certain amount of debt it has to sell every month to fund all of its bloated spending commitments.

When the world is already stuffed with American paper, though, there’s only one way to bring buyers to the table: Higher yields.

As such, one of the aftershocks of the Great Sendai Quake will ripple 6,600 miles away, in Washington, DC, where the Treasury Department will have to pay more to access the money it needs to fund America’s overgrown spending demands.

That will make it even more expensive for America to fund its obligations.
Who knows what the ramifications of that will ultimately be? Will Congress accede to QE III? Will rising interest rates here be mildly inflationary (after all, the Fed can’t cut rates any lower)? Will Congress be more amenable to raising tax rates?

And what of stocks? Japan owns more than $1 trillion in U.S. stocks, equal to about 6% of the total value of the New York Stock Exchange. Selling off any sizable portion of that will clearly put downward pressure on American equities.

from Jeff Opdyke